21 July 2010

Calculated Risk on the Housing Credit And More

The housing tax credit was a clear and unequivocal failure. Not only did most of the benefit go to people who were going to buy anyway, but the credit didn't reduce the overall supply (the total supply includes both homes and rental units). The credit just incentivized some people to move - and pulled some sales forward - and to the extent the credit went to new home sales, it actually was counterproductive by increasing the excess supply. This is a textbook example of bad policy.

The Housing Market Is Not Very Responsive To Incentives In Anything But The Very Short Term

One criticism is that the increase in home purchases per tax dollar spent was very small, and it will be even smaller once the post tax credit sales slump is taken into account.

Each additional home purchase produced by the tax credit cost American taxpayers something on the order of $150,000 (the credit was about $8,000, but the housing market statistics imply that about 94% of the buyers are people who would have bought homes anyway without the credit).

There are cheaper ways to stimulate a weak economy.

The Rule of Holes and the Value of Useless Things

The other criticism is that to the extent that the credit induced builders to build new homes, it made a bad situation even worse.

The first rule of holes is that when you have dug yourself into one, stop digging.

The proximate cause of the financial crisis was a housing bubble that collapsed in several regional U.S. housing markets. This caused the financial industry which had financed the bubble to choke, and this in turn led to a generalized, deep recession in the U.S. economy. The reason that housing bubble happened is disputable. The fact that there was a housing bubble that collapsed is not.

A housing bubble is a situation in which housing prices continue to increase far beyond the prices that economic fundamentals would suggest. In other words, it is a situation in which the market screws up and collectively overprices houses for a while.

Excessively high prices lead the market to build more houses than it should.

When a housing bubble collapses (and all price bubbles ultimately do), the market suddenly acknowledges that it has built more houses than it should have built.

It should be pretty obvious that the building more houses is not the right thing to do when the nation has too many houses.

But, politicians being politicians, it isn't. Business journalists, likewise, seem to have a hard time grasping the concept that maybe it isn't such a bad thing that the market has woken up and decided to stop building more houses when we already have enough of them. Their tendency is to see more construction as something that is always good, whether we need it or not. Gross Domestic Product (GDP) numbers share the same bias. More is always viewed as a good thing.

What politicians, business journalists and macro-economists often forget, but our capitalist economy fortunately does not, is that making more of something is only worthwhile if someone wants it badly enough to pay what it costs to make it. Making things that people don't want at the price it takes to make them does not add value to the economy.

Building houses that the economy doesn't need does not make us richer.

Perspectives On The Net Worth Slump

The housing bubble collapse has been a blow to the the aggregate net worth of American households. NPR discussed the second quarter report from the Fed on the subject. Just before the housing bubble collapsed and the financial crisis hit in 2007, the nation's net worth was about $65 trillion. As of June 30, 2010, the nation's net worth is down to about $54 trillion (about $180,000 per capita, although obviously not evenly distributed), which is were it was back in 2004.

Declining net worth sucks, and a 17% drop in a couple of years is not small. Declining net worth especially sucks if it happens to you. And, it is worth recalling that asset values have fallen even more than 17% because both assets and liabilities have fallen.

Still, a lot of the declines in asset prices were only on paper. Asset valuations were inflated in 2007 and have since returned to more normal levels. Lots of people owned real estate before prices surged, held onto it, and still own it now that prices have dropped. Those people still own precisely what they did before, it just looks different on a balance sheet.

When In The Boom-Bust Cycle Is Harm Done?

I don't mean that the financial crisis or the recession that followed weren't bad things. I am simply pointing out that a restoration of asset prices to levels more in line with reality is not the reason that the economic events of the last decade were bad.

The bad part is that a lot of people acting in reliance on artificially high asset prices made bad decisions. They borrowed more than they should have borrowed using their homes as collateral, and saved less than they should have saved. They hired people to build houses that the economy didn't need and had to lay them off because there is now an excess inventory of housing. They made unsustainable projections of future demand for all manner of public and private sector goods and services and ramped up to meet demand that never materialized. They squandered our society's pool of resources available to invest in new business ventures on financial and real estate investments, when it would have been better for our economy if that capital was available now to fund new biotechnology and high tech ventures.

Most of the decisions that were bad for our economy were actually made during the boom, not the bust. The bust is just when we collectively figure out that we were previously stupid. By the time a bust happens, some consequences of prior bad decisions are inevitable.

What Policy Options Do We Have?

We can try to economically punish those who made the bad decisions in order to set a precedent that will discourage bad decision making in the future. We can try to buffer the innocent from suffering the full consequences of someone else's bad decisions. We can try to repair problems in our political economy that encouraged people to make bad decisions. We can try to turn lemons into lemonade by making the best of the situation we inherit. But, nothing can change the fact that we built more houses than we needed, or otherwise made bad decisions in reliance on artificially high asset prices.

A long history of trying has also revealed that boom and bust cycles can't be avoided all together. Sooner or later our current round of fixes to the political economy will fail. If we do a good job, this will happen later. If we do a bad job, it will happen sooner. But, there is every indication from economic history that boom-bust cycles are an inevitable part of any capitalist economy.

The Case For A More Robust Economy

It isn't nearly as obvious that we can't mitigate that harm caused by boom-bust cycles.

Notwithstanding the many banks that have failed in the financial crisis, commercial bank failure rates post-FDIC are still lower than they were when the economy was healthy pre-FDIC, and mass institutional collapse was largely restricted to the less regulated shadow banking sector this time around. Commercial banks lost heaps of money, but, because there were limits on their leverage imposed by the FDIC, this didn't bring down a very large share of them.

There is still reason to believe that we can reform our political economy in a way that makes our economy more robust, so that the consequences of collapsing price bubbles and other economic sins that lead to recessions lead to less displacement for ordinary people. We can remove subsidies for leverage, we can provide people with more transferable skills, we can strengthen the social safety net, and we can put in place other automatic stabilizers in the economy.

Can Every Bucket Stand On Its Own Bottom? What Does This Imply For Federalism?

A harder question is whether it is possible or desirable to reduce the tight interdependence our economy. Was it inevitable that overpriced houses in California and Florida would produce lay offs for auto workers? Did a regional crisis in the U.S. have to spread to other regions and abroad? I don't know the answer to that question.

A lot of the gains that our economic system produces come from its interdependence. Wall Street is not wealthy because Manhattan is home to highly productive workers in the real economy. Silicon Valley is not an economic powerhouse because Californians need more computers than anybody else. Florida orange farmers and cranberry producers in Maine do not thrive because their neighbors have a strong commitment to buying local. Seattle is not prospering because Washington State has a particularly high demand for commercial airplanes or buggy software. The interdependence of our national and global economy is part and parcel of what makes it thrive.

But, if our economic system is indeed interdependent, then the case that the rules governing that process need to be made at a high level is great too. The entire world has suffered, in part, because the legislatures of California and Florida were overprotective of homeowners vis-a-vis banks. No amount of good policy from legislative bodies in other states mattered. Policies anyway that make create incentives that favor major price bubbles in any economically significant good or service can wreck havoc globally.

The implication is that making economic policy locally is like handing out loaded guns in bars near closing time. The vast majority of the people there may act responsibly, but it is almost inevitable that someone will make a very bad decision that hurts some other completely innocent person. Local control only makes sense in the political economy when the decisions don't have powerful externalities, and in an interdependent economy, many local economic decisions do impact people who have no say in them.